ECON430-Topic #3: Negative Interest Rates

Last April, during what appeared to be a U.S. economic free fall, Greg Mankiw wrote an op-ed in the New York Times advocating some unconventional strategies for trying to achieve a negative nominal interest rate. The point of trying to institute a negative interest rate would be to stimulate demand by discouraging savings and promoting consumption. However, other economists such as Robert P. Murphy at the free-market advocate Ludvig von Mises Institute harshly criticized Mankiw’s logic. Mankiw later noted that Fed research showed that the policy rate should have been set to approximately -5% if something close to the Taylor Rule were followed. Other economists such as LSE’s William Buiter advocated some similar strategies to those recommended by Mankiw. There have also been several cases where currencies have been devalued in nominal terms, such as was suggested by Mankiw in his NY Times piece. The Swedish Riksbank has also employed similar strategies to support increased lending.

Questions you might try to answer:

  • Do you believe that a negative nominal interest rate would be a useful strategy in the United States? How do you think this might have been instituted, and do you think it would have had the desired effect?
  • How do you compare the Fed’s quantitative easing measures to those suggested by Mankiw, Buiter, or Murphy? Have they achieved their goals?
  • When contemplating the exit strategy of the central bank after all of this easing, which strategy do you believe the Fed would be able to exit most easily?

17 thoughts on “ECON430-Topic #3: Negative Interest Rates”

  1. The idea of a negative interest rate seems too simple. Murphy’s article does a good job of pointing out some problems with Mankiw’s thinking. Individuals and households form their preferences for purchasing items on many variables, not only interest rates. I don’t think using the negative interest rate approach will magically cause individuals and businesses to spend. As Murphy suggests, change in interest rates affect mostly durable goods, so at the outset we are only talking about a fraction of the economy. And wouldn’t the stock market feel the pains as consumers switch spending patterns? Would this create unwanted fluctuations in the business cycle? The economy is too complex to succesfully predict the outcomes of such an experiment. I think applying the reasoning “It worked in Sweden, it might work in the US” is a wrong argument to undertake. Sweden has a different economical structure, and not to mention that it is a member of EU, although it has not adopted the Euro. (1) This coupled with Sweden’s weird labor-union market create a different environment in which interest rates operate. Fiscal and monetary policy have different implications. As far as implementing negative interest rates, the government could abolish existing currency, separate the dollar’s unit of account/means of exchange function, or taxing currency holdings. (2)

    1) https://www.cia.gov/library/publications/the-world-factbook/geos/sw.html
    2) http://www.voxeu.org/index.php?q=node/3626

  2. I agree with Saric in that negative interest rates may seem too simple to implement. Mankiw asks the question, “why don’t we lower interest rates”? He states this could be possible if the Fed commits to forcing inflation. However, this may be no easy task. Federal Reserve Vice Chair Donald Kohn said that he doubts “households and businesses would immediately adjust their expectations up to the new targets” (1). Even if the Fed can commit to this effort, will the public’s expectations match their intentions? Furthermore, when contemplating the exit strategy of the central bank, do any of these articles present easy exits? Janet Yellen, President of the Federal Reserve Bank of San Francisco, stated the “economy is too weak to withstand rising interest rates” and she “would favor negative interest rates” (2). This seems to be the easiest route. However, as Murphy argues, it is doubtful the United States would be willing to destroy the dollar in order to fix the economy. The easiest strategy for the Fed may be to maintain interest rates for now, even if this is not the brightest idea in the long run.

    1)http://imarketnews.com/node/10808
    2)http://www.fxstreet.com/fundamental/interest-rates/us-fomc-expected-to-hold-policy-steady-tuesday/2010-03-15.html

  3. Since earlier this year, when the Fed announced possible exit strategies, the Fed has avoided committing to policies that would greatly increase inflation. However, recently the Fed has seen incredibly low inflation rates as too big of a problem to ignore, and they have now committed to a new strategy. The Fed plans to pump $1.2 trillion dollars into the economy to raise inflation rates and therefore avoid the dangers of deflation, which was becoming a possibility (1). This strategy is very similar to Mankiw’s proposal to have the Fed commit to a high inflation rate and therefore causing real interest rates to be negative while nominal interest rates remain close to zero. However, as James Hamilton points out, the Fed is probably not thinking in long-run terms (2). Instead, this dumping of money into the system will most likely be stopped by the Fed as soon as the inflation rate is somewhere around 3%. The hope is that this rise in inflation will be enough to induce consumption now. As other sources in this blog have pointed out, one strategy will not be enough to execute a successful exit by the Fed. Nonetheless, this rise in inflation rates is an adequate step towards a complete exit, because recently abnormally low inflation rates are threatening to make the economy descend into an even tougher situation to fix.

    1) http://www.washingtonpost.com/wp-dyn/content/article/2009/03/18/AR2009031802283.html
    2) http://www.econbrowser.com/archives/2009/03/quantitative_ea_1.html

  4. I feel that having a negative interest rate is a bad idea right now for the United States economy. The last thing the world needs is the United States to try to dramatically change the interest rate. Right now businesses and banks are trying to enter into new contracts, and the last thing they need to worry about is uncertainty of interest rates. I feel this will only cause economic confusion, slowing the recovery process (1). If the Fed really wanted to lower the interest rate to a negative number, they could continue to print large sums of money. This will cause the money to devalue, and may form negative interest rates.
    The Fed is going to have a hard time with their exit strategy. The markets cannot handle the unloading of all the assets the Fed currently owns, and it will take years for the Fed to finally rid themselves from the quantitative easing. They Fed has said they will eventually unload the assets, but have not offered a timeframe (2).
    (1) http://www.essortment.com/all/differencesbetw_roqj.htm
    (2) http://www.businessweek.com/investor/content/feb2010/pi20100210_790833.htm

  5. Why would a negative interest rate be necessary. Our interest rate is already very close to zero. Most people are not going to save if their interest rate is zero right? So why would we need to make it negative to get people not to save and instead spend. The governemtn surely would invest at a zero interest rate. This is why many people believe that a government deficit is good in a recession because the Fed will have to fund this deficit and this means they would send the money they borrow to millions of people (North 1). As Gary North pointed out there is no real reason why interest rates have to go below zero for the Fed to buy T-Bills. North agrees though that if we did have negative interest rates then it could stimulate spending. He suggests as an exit strategy that the Fed offer negative interest rates on excess reserves. This essentially would be a storage fee on the banks, which would force them to loan out their money at a lower rate and people would start spending again. This of course could lead to large inflation so all in all its tough to say what the Fed should do….

    http://www.lewrockwell.com/north/north758.html
    http://gregmankiw.blogspot.com/2009/04/observations-on-negative-interest-rates.html

  6. While the fact that there are many economists thinking about solutions to this crisis is indeed comforting, the publishing of Dr. Mankiw’s article in the New York Times is close to alarming. The policy prescriptions of the Harvard professor are not consistent with the real economy. The risk of inflation itself undermines US markets and is not justified by the output gap created by the recession [1].
    The lower interest rates are also unlikely to increase spending, as private consumption is limited by people’s perception of the markets. Confidence levels are still low [2], and credit is tight since banks are holding on to their excess reserves as those yield higher and safer returns to the institutions [3]. There is fear in the economy that this wide variety of “stabilizing” policies may lead to worse outcomes [4] than if policy-makers had stuck to laissez-faire Economics and let the economy be.
    Since the case for lower-than-zero interest rates cannot even be seriously considered as a viable policy for the United States, the final consideration is a follow-up to my last argument. The use of monetary policy to match fiscal stimuli cannot be continuously brought about to “save” the economy. There are few, if any, instances when limited government intervention has proven to be effective in the long run in helping the economy.
    [1] http://www.reuters.com/article/idUSTRE62P48520100326
    [2] http://research.stlouisfed.org/fred2/graph/?&chart_type=line&graph_id=0&category_id=&recessi on_bars=On&width=630&height=378&bgcolor=%23B3CDE7&graph_bgcolor=%23FFFFFF&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=UMCSENT&transformation=lin&scale=Left&range=5yrs&cosd=2005-02-01&coed=2010-02-01&line_color=%230000FF&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2010-03-30&revision_date=2010-03-30&mma=0&nd=&ost=&oet=&fml=a
    [3] http://research.stlouisfed.org/fred2/series/INTEXC1?cid=118
    [4] http://articles.chicagotribune.com/2010-02-25/business/sc-biz-0226-stocks-20100225_1_double-dip-recession-double-dip-durable-goods

  7. I don’t think negative interest rate would be useful strategy in the United States. The Fed lowered the interest rate to zero increasing the availability of credit in the economy to motivate the spending among consumers. Then, the Fed initiated IOER policy as exit strategy to avoid inflation. Now, the banks are holding considerable amount of money in Fed as excess reserve. If the Fed will go negative, it means the discount rate will be negative. Thus, the banks instead of getting negative interest rate on their excess holdings in the Fed will lend this money out. But as soon as the banks pool all this money from reserves it might lead to mass inflation (1). The Fed is hoping that this strategy will discourage savings and motivate consumption. However, negative real interest rate might motivate people to borrow but not necessarily spend. As indicated in the article (2) US consumers are in deep debt today. The statistics show that until the debt levels would fall significantly the borrowing for consumption and for businesses would stay low.
    1) http://www.lewrockwell.com/north/north758.html
    2) http://seekingalpha.com/article/163788-negative-interest-rates-aren-t-a-solution-to-the-crisis

  8. Ideas and drastic changes that stray from the accepted norm are always met with resistance. However, as off the wall as the suggestion may seem the fed has found itself in “uncharted waters” [1] and perhaps this may be the start to a path to get us out of our current situation. It is easy to attack the adoption of the negative interest rate on the principle that the availability of currency will ruin the effectiveness of the policy. As well as the idea of destroying some amount of currency in order to create incentive to hold bonds rather than cash. But, is destroying currency really necessary? Pollock points out that if negative interest rates were adopted there will be a switch to currency in order to complete smaller transactions, there will also be a certain amount of currency hoarding as is being forecasted by the critics of the negative interest rate. But, the issue remains that in the case of large transactions such as the paying of salaries as well as the issuing of social security checks, currency would be both impractical as well as an insecure mode of transferring funds. The fact also stands that people regularly are exposed to a negative interest rate every time that they withdraw funds from an ATM at a bank that they are not the customer of. Basically this huge reliance of people on electronic transactions is what makes the idea of the adoption of negative interest rates feasible [2].

    1. http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1
    2. http://www.american.com/archive/2009/may-2009/why-not-negative-interest-rates

  9. I’m going to agree with Drazen and say that the idea of a negative interest rate seems too simple. Murphy points out that if interest rates fall, consumers and businesses don’t simply buy more goods, but more particular goods (durable goods). If interest rates fall below zero and individuals don’t purchase durable goods, why wouldn’t they just hoard? The only way to keep people from hoarding would be to tax their held currency. Williem Buiter suggests doing this by having currency holders come forward and pay a tax on currency held longer than a restricted period of time (1). While this idea could work I think overall it would cause confusion not to mention inconvenience. Buiter also makes the suggestion of abolishing currency, which Murphy furiously shoots down. It is also another situation I think would lead to panic and confusion in the economy. As stated previously, the idea of negative interest rate is much more complex than Mankiw leads to believe, and in general I feel it is too much of an unconventional strategy.

    http://www.voxeu.org/index.php?q=node/3626

    http://seekingalpha.com/article/163788-negative-interest-rates-aren-t-a-solution-to-the-crisis

  10. Two main issues come to mind when considering negative interest rates: the housing bubble and the value of the dollar. Let us not forget that the housing bubble was due largely to the long standing existence of low interest rates and an excess amount of borrowing, inflating the prices of houses and then ultimately a collapse. Yes, I will advocate the fact that a negative interest rate may spur spending, but to what extent. Homeowners that lost their jobs and then their houses are beginning to be hired again (recent economic data shows that employers added the most jobs in March 2010 in three years) [1]. So, will the artificially low interest rate cause an increase in spending and banks beginning to extend loans to people to buy houses that couldn’t afford them the first time around? When looking at a negative interest rate on a global view, a negative interest rate could weaken the dollar. Yes, people would be excited that they could pay back their loans with devalued dollars and this will spur spending, however, the foreign investors holding US financial assets and dollars in their currency reserves will not be excited by this change as their investments’ value will decline. This could spur a run on the dollar and we would have bigger issues that we have already. I commend the Fed and economists for coming up with new and interesting ways to spur growth in the economy, but in agreeing with Robert Murphy, it’s important to not forget basic economic principles.

    [1] http://finance.yahoo.com/news/Employers-added-most-jobs-in-apf-1200861720.html?x=0&sec=topStories&pos=main&asset=&ccode=

  11. I think having a negative nominal interest rate would be a bit crazy. What person in their right mind would want to lend money out to someone and not get back that equal amount or more in the future? In addition, Murphy makes a very good point when he says that interest rates are not just uses a policy tool for the Fed (1) Would a negative interest rate lead to another bubble in a different sector of the economy in a couple of years? The only way negative interest rates would work would be for the government to eat the cost and raise taxes in the future.
    From my own understanding of quantitative easing I think the idea of destroying money all together would be a great idea. In the short run I think people would see their money in a different way. It would loose some of it’s physical identify and people would be able to spend their money in more places. This would lead to all kinds of needs for having computers and online banking, and this would take some time. However, during times like this people are watching their money a lot more, and if they see that the money they are holding on for a rainy day is not doing much for them in gaining interest then they would be much more likely to spend that money. However, Buiter does bring a valid point. Moving to this would cause problems because people may not feel like their information is safe or crime on the net could increase (2).
    I think the best exit strategy for the Fed is to first and mostly importantly is to educate the public on what the Fed does and try and gain back the trust of the people. I think once this happens people will be much more likely to believe and trust in what the Fed does and says. It seems like the Fed was only looking out for the banks and trying to insure that they were all right while people were just second in line. I study this stuff, and to be it seems like a roller coaster ride mixed in with some crazy funhouse with to many mirrors.

    1. http://mises.org/daily/3432
    2. http://blogs.ft.com/maverecon/2009/05/negative-interest-rates-when-are-they-coming-to-a-central-bank-near-you/

  12. In the United States I do believe that a negative nominal interest could work if the FED was willing to take heat from the country for unconventional measures. I know that the FED is independent but I really believe that a lot of the FEDs moves today are governed by popular sentiment. I honestly just don’t think it will ever be implemented due to the shaky grounds the FED is already on. If they were to implement however, I believe they could simply do some sort of quasi script model in which maybe money is devalued every so often. I don’t think that I will have the desired effect, I think what it would do is it would create an even larger base of people against the FED. It is kind of too complicated to understand for people (for lack of better phrasing) to believe in. We are learning now in Monetary theory that a lot of the problems associated with money supply and the liquidity trap are associated with what people think is going to happen. If we have the country rebelling against the FED their policies will most likely be rendered useless. Plus, as with the Taylor rule, the FED and Bernanke are simply to late because if they had followed the rule they should be already implementing some form of negative interest rate. Unfortunately I don’t believe there is an easy strategy for exiting a situation quite like this one. The FED is going to figure out how to sell all of the illiquid assets that they have on the books and limit their loses in the process. I believe however after seeing the Jobs report today that the FED may luck out and the economy may just self correct. As I have read though currently I do support the IOER approach being currently implemented by Bernanke. A big part of this, reiterating, is going to have to come from the PR side of things and convincing people that it is safe to invest and consume, not just simply save.
    http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html
    http://money.cnn.com/2010/04/02/news/economy/jobs_march/index.htm?hpt=T2

  13. We are in a real economic situation here that needs real economic solutions. What some economists have been suggesting, in my opinion, is not realistic at all. Mankiw discusses a plan to remove currency from the system and he is not the only one to suggest it. The difficulty of implementation as well as the huge political backlash that this type of policy would cause makes it completely unrealistic in my opinion. Destroying 10% of an person’s holdings would be viewed as a vicious attack on an individual’s well being by the federal government.
    Instead we need solutions that we can actually use. This is where Sweden comes in. I really like their idea of basically taxing deposits at the central bank. Negative deposit rates would put pressure on banks to lend rather than hold their money. Mike Shedlock criticizes the policy saying that it could create a run on deposits (1). Others suggest that this would lead to reckless lending (2). Though there are certainly risks to the policy, doing nothing will doubtfully solve the problem and this is a policy that can be enforced easily and allows for a fairly easy exit verses many other solutions that economists have suggested.

    1. http://globaleconomicanalysis.blogspot.com/2009/07/sweden-cuts-deposit-rate-to-negative-25.html
    2. http://seekingalpha.com/article/147023-on-sweden-s-negative-interest-rates-and-quantitative-easing

  14. I tend to agree with Murphy and the Mises Institute that negative interest rates are not the correct path to alleviate stress from a recession. The free-market will never come to equilbrium where there are negative interest rates because this is unsustainable and there is no incentive to lend money because of a negative real return on loaned money. Murphy’s example of Alan Greenspans policy after the dot.com crash, which was to lower the FFR to 1%, artifically increased the activity in the housing market, which probably influenced the recession we are in today. Attempting to exogenously influence aggregate demand today would likely have the same effect in creating an unsustinable boom in some industry. The FED’s quantitative easing program has increased funds available to loan within the economy in the short-run, which may have helped ease the recession, but this has just made their exit strategy in the long-run significantly more tough. With all the excess liquidity currently within the system the Mankiw proposition of high inflation to influence consumption would call for no exit approach at all, just leave the banks to decide how the funds should be used. Murphy would most likely suggest an exit strategy where an unrestricted market would be allowed to reutn to equilibrium without external influences

    http://krugman.blogs.nytimes.com/2009/03/20/fiscal-aspects-of-quantitative-easing-wonkish/

    http://www.lewrockwell.com/north/north758.html

  15. I think it’s fairly obvious that Mankiw’s article is flawed, as many others have already contested. Without being too repetitive, the biggest problems I can see with his proposed ideas would be that when the interest rates fall, this doesn’t influence the consumers’ purchases of every single variety of goods, just a select few such as cars and houses, not cereals or tennis shoes. This means that only some companies would benefit. (1) Secondly, I think this was a key part of Murphy’s article, was that one of the main reasons we have reached this recession in the first place was Greenspan’s policies of dropping interest rates to around 1% after the dot-com crash to do pretty much exactly what Mankiw is proposing. In other words, it seems that a policy like this has already been implemented and the end results were, clearly, far from effective. I believe the section of the article that Mankiw mentions about devaluing 10% of the currency at the end of year isn’t meant to be taken completely seriously, but more of just a hypothetical idea thrown out to the world to think about. Even so, I definitely think the biggest problem with this idea is that the cash economy would definitely come to a screeching halt. Nobody would want to accept these bills toward the end of the year, people would be finding ways to hedge against the devalued digit, and coins would be hoarded. In other words—chaos. (2) Also, Mankiw doesn’t acknowledge the fact that the actual held currency is hugely less significant than the amount of the money supply that is in banks and other accounts. Finally, as for inflation targeting, this has always been an idea that has been passed around, but there are definite flaws with this as well. Mike Shedlock argues that inflation targeting is morally wrong because it benefits those with first access to money. (3) I thought Mankiw’s article was interesting, and he is indeed a good writer by economist standards, but it was more fantasy than reality.

    1. http://mises.org/daily/3432
    2. http://globaleconomicanalysis.blogspot.com/2009/04/time-for-mankiv-to-resign.html
    3. http://globaleconomicanalysis.blogspot.com/2009/04/inflation-debate-volcker-vs-kohn.html

  16. I agree with Anna that negative interest rates cannot be used as a viable monetary policy. The op-ed by the Harvard Professor, Greg Mankiw suggests that, “the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates — interest rates measured in purchasing power — could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend.” (1) This policy prescription towards inflation to induce a negative interest rate assumes an automatic increase in consumption. A negative interest rate might encourage borrowing and discourage saving, but does not guarantee that people will spend. “Negative interest rates will prompt people to borrow and hold on to the money, only to return a lesser amount to the bank later, but they are unlikely to use the money for either consumption or production.” (3) Confidence levels in the market are still very low and a majority of Americans have a great deal of debt, so it is very possible that the money borrowed would be hoarded rather than spent for consumption. “The US consumers are neck deep in debt and are only likely to begin to borrow more once the debt levels fall to manageable levels.” (3) “Perhaps the single biggest mistake in Mankiw’s worldview is his treatment of the interest rate as merely a brake or governor on “spending” (2) Mankiw’s views on interest rate manipulation are very simplistic and do not consider how interest rates “coordinate production and consumption decisions over time.” (2) Mankiw does not take into account the complexities and consequences of drastically changing the interest rate and its varying long term effects in different sectors of the economy. Furthermore, the policy of inflation to achieve a negative interest rate is somewhat ridiculous. Robert Murphy critiques, “Mankiw’s worldview leads him to literally propose destroying the currency in order to fix the economy. That alone should have set off warning bells.” (2) The problems associated with mass inflation and the consequences of such a Fed commitment are not reasonable tradeoffs for a simplistic and naïve approach to increasing borrowing and consumption that most likely will not succeed.
    In contemplating the exit strategy of the Fed after there policy of quantitative easing, I do not believe there is any clear or easy solution in sight. The Fed is currently holding massive amounts of toxic assets worth a fraction of their former value before the financial crash. Though the Fed has claimed that they will eventually dump these assets back into the market once the economy has recovered, there is no foreseeable time in the near future of when this will actually happen. “Bernanke said he does not expect to sell any of the Fed’s security holdings until “after policy tightening has gotten under way and the economy is clearly in a sustainable recovery.” (4)

    SOURCES
    1) http://www.nytimes.com/2009/04/19/business/economy/19view.html?_r=1
    2) http://mises.org/daily/3432
    3) http://seekingalpha.com/article/163788-negative-interest-rates-aren-t-a-solution-to-the-crisis
    4) http://www.businessweek.com/investor/content/feb2010/pi20100210_790833.htm

  17. I don’t think a negative interest rate would be an effective strategy in the U.S. Mankiw and Buiter’s view is just overly simplified and hypothetical. According to Mankiw, if Fed commits itself to produce significant inflation, so that inflation rate exceeds the nominal interest rate, the real interest rate would become zero, and people will borrow and spend instead of saving. However, it is not as simple as it sounds. Firstly, in the short run, even if Fed announces that the target inflation rate would be significant, we don’t know what would the public expectation would be. If people do not believe what Fed says, Fed’s plan would not be effective. If people believe Fed’s announcement, people who currently have debt will simply borrow money and repay their debt, and it would be like the Fed paying the debt for them. Also, in the long-run, it would not be an ultimate solution. As Murphy wrote, not all the sectors are interest rate sensitive, and therefore,*if people decides borrow and spend*, they will spend on some particular items. And I think most spending would be on speculative items (not necessarily in the U.S.). That would create another bubble on the particular market as we experienced before (the housing bubble which triggered current mess), and we will experience another problem after all. Moreover, it would be not easy for the Fed to create such a significant inflation. To create inflation, the Fed should supply money in the economy. However, currently, we already have problem with too much liquidity as we discussed in previous blog posting. And the Fed is trying to control the liquidity by letting the banks keep their excess money in Fed by paying interest on excess reserves. If the banks expect an inflation rate above nominal interest rate, they will take out their excessive reserve currently sitting in Fed’s vault, and we will have more severe liquidity problem. Furthermore, internationally, the creditors to the U.S. would not be happy about it. We could also expect the U.S. currency becoming the new carry-trade currency. How is the U.S. going to deal with the problems?
    There would not be such a quick and easy way to exit from current situation, but I can say that lowering the interest rate to negative would not be a good idea. I think the Fed’s job at this point is to let the economy recover slowly (as it seems that the economy is recovering) and try to control the excess liquidity during the recovery by using IOER and repurchase agreements.
    http://www.nasdaq.com/newscontent/20100318/Beware_of_the_dollar_carry_trade.aspx?storyid=20100318173044equit
    http://www.businessweek.com/news/2010-04-02/u-s-economy-gain-in-payrolls-shows-recovery-more-entrenched.html

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